State Bank of
Pakistan's Shariah Board has reviewed and approved the essentials of
Islamic modes of financing

By SHABBIR H. KAZMIAug 09 - 15, 2004

The Islamic financial services industry, despite
its remarkable growth during the last few years, is still in its
infancy and needs careful nurturing and development to make a
perceptible impact in the global financial markets. The creation of
institutions such as IFSB, AAOFI, IIFM, etc. has given rise to
expectations that the constraints and impediments facing this industry
will be tackled in a systematic and informed manner.

Dr. Ishrat Husain, Governor, State Bank of Pakistan
has highlighted six major challenges facing the industry those need
priority attention of all the stakeholders, particularly the
regulators, market participants, judiciary and religious scholars. He
also believes that the thrust of the future deliberations should shift
from generalized discussions to focused discourse so that some headway
can be made and progress monitored and measured in the achievement of
the objectives.

The six challenges identified by Dr. Husain are:

1) Islamic
financial service industry (IFSI) has to safeguard and maximize the
interests of major stakeholders for enhancing its market share from
the existing insignificant level. There are four major stakeholders in
this industry — three are common to both conventional and Islamic
but the additional stakeholder in case of Islamic finance is the
Shariah scholar, who have to be satisfied that the products are
compatible with Shariah precepts and principles. Not only that there
is an additional stakeholder, the nature of relationship between
Islamic finance service provider and other stakeholders is also quite
different.

Customer relationship is varied, complex and
multiple. The relationship ranges from that of a buyer and seller (Murabaha);
transferor and transferee; lessor and lessee (Ijara); guarantor and
guarantee; depositor and custodian; partner and partner (Musharika);
investor and working manager (Modaraba). In conventional banking there
are only two forms of relationships i.e. borrower or depositor.

Risk premium in IFSI is relatively high while risk
mitigation, risk allocation and risk transfer techniques are not that
well developed; unless risk adjusted returns are equalized across the
two market segments, the IFSI growth will remain stunted. Absence of
hedging products places the Islamic products at a relative
disadvantage as far as risk mitigation is concerned.

Standards and codes, Principles of Corporate
Governance, internal controls, disclosure and transparency have to be
separated and made distinct from conventional banking to reflect the
peculiar characteristics of IFSI. Some progress has been made but
still there are a lot of knotty issues to be settled.

There are conflicting pronouncements and continuing
debate as to what is and what is not permissible under Shariah. These
controversies in the interpretation of Shariah precepts among scholars
from different Fiqahs and create a lot of uncertainties among the
potential investors who then shy away from taking a plunge in the
Islamic products keeping the overall size of the small market.

2) The legal
framework provides confidence to stakeholders that the courts can
enforce their rights and obligations, if and when a situation arises.
But in case of IFSI there is both ambiguity and lack of predictability
about the enforceability of contracts under the Islamic Banking. For
example, there is a dual judiciary system in Pakistan. Jurisdiction of
Courts is unclear — whether Civil or Shariah Courts will take
cognizance and decide. Dispute resolution mechanisms such as
mediation, conciliation and arbitration are not binding under the
existing legal system and practices, although litigation is not the
preferred mode of dispute resolution in Islam. Judges lack training in
banking and Shariah. Lawyers are not trained in Islamic banking and
finance. Case law and precedents from one system such as English law
are not binding. Enforcement mechanisms are found wanting.

3)
Accounting, Auditing, Taxation and Information Support Systems have to
evolve over time. Infrastructure for Islamic Financial Institutions (IFIs)
is still underdeveloped and will take time and efforts. To that extent
conventional banks will have an edge over the IFIs, AAOFI and IFSB are
the right vehicles and must accelerate and disseminate their work. Tax
differentials do erode the competitive edge of IFIs and will amplify
the divergence. These differentials will have to be removed to provide
equal tax treatment to both segments of the market, i.e. IFIs and
conventional.

4) Product
Innovation and Development should move ahead to keep pace and provide
alternative options that are at least as attractive as conventional
products with the additional stipulation that these products should be
Shariah compliant. Standardization, harmonization and application of
Shariah compliant products based on some general principles should be
promoted. A menu approach whereby the markets can develop and
documents new Shariah compliant products rather than await for ex-ante
approvals of Shariah Boards in each single case will enhance the
response capacity of Islamic financial markets and enable them to
compete with conventional products. At present, the transaction costs
of Shariah compliant products are higher relative to the traditional
products and have to be reduced by adopting this menu approach.

5) Human
Skill Development that includes selection, training retention and
continuous capacity up-gradation of the managers and staff of IFIs are
essential for the success of the Islamic financial system. Islamic
financial industry has to make strategic investment in all these areas
as hiring and merely re-labeling conventional bankers as Islamic
bankers is not going to work in the long term. Managers and leaders in
this industry are badly missing and unless we can identify, find and
empower them the rest of chain in human skills development will have
important missing links. Dogmas, strongly held opinions and
narrow-minded beliefs in some rigid doctrines of the religion should
not be allowed to dominate the field. Open minded, pragmatic and
innovative men and women committed to the growth of Islamic financial
industry should be encouraged and drawn into this profession.

6)
Inculcation of Islamic values of integrity, ethics, truthfulness,
justice, compassion and absence of exploitation among the Ummah will
provide the glue and adhesive that will make this stick in the long
run. If the practice of values move in one direction and the financial
system evolves in the other, the foundation of the system will get
weakened over time and it will not be able to withstand the tremors
and vibrations created by exogenous shocks.

The Commission for Transformation of Financial
System set up in the State Bank of Pakistan in pursuant to the Supreme
Court Judgment on Riba dated December 23, 1999 approved essentials of
Islamic modes of financing including Musharaka, Mudaraba, Murabaha,
Musawama, Leasing, Salam and Istisna. The recently established State
Bank of Pakistan's Shariah Board has reviewed and approved the
essentials of Islamic modes of financing and recommended that the same
may be circulated to the banks conducting Islamic banking business in
Pakistan as guidelines that would form the basis for Prudential
Regulations on Islamic banking in due course. It does not preclude the
possibility of developing new modes or instruments of financing,
modifications or variants of the modes provided these are Shariah
compliant.

ISLAMIC MODES OF FINANCING

These Guidelines/Essentials are proposed to be
enforced as Prudential Regulations for Islamic banks in due course.
The State Bank invites suggestions and views for enforcing them as
part of Prudential Regulations from all concerned, particularly the
Shariah Scholars, Academics, Bankers and the Business community. With
dual objectives of facilitating the existing Islamic banking sector
and the potential market players to develop Islamic banking products
in particular and to create awareness about Islamic banking products
in general, Model Agreements for following modes, vetted by the
Shariah Board, have also been placed on SBP website.

It may be pointed out that these are model
agreements, which can be modified, according to the products designed
by the banks conducting Islamic banking business, with the approval of
Shariah Board of Islamic Commercial Banks or Shariah Adviser of banks
having Islamic banking branches, ensuring that such changes are
consistent with the principles of Shariah.

The experience in Islamic banking operations around
the world reveals that transformation of retail banking is not a big
problem. The financial sector in Pakistan is already familiar with the
concepts of Islamic banking and finance and some of the financial
institutions are already practicing it. However, there are problems in
development of instruments for liquidity management by banks and
monetary management by the State Bank of Pakistan. Government's
financial transactions constitute a large part of the financial system
of the country. Banks and financial institutions have sizable
investment in government securities. The monetary management is also
primarily linked to transactions of government securities. Therefore,
the process of Islamization of financial system crucially depends on
development of instruments for Shariah compliant government financial
transactions. The development of instruments and restructuring the
national/public debt on the Shariah compliant poses a serious
challenge.

The introduction of Islamic Banking System is a
long process requiring development of legal and regulatory framework,
institutions, markets, and efficient and appropriate practices. This
process requires constant monitoring and fine-tuning. Since a lot of
work has already been done, Pakistan can benefit from the experience
of other countries. It seems that Pakistan is following the example of
Malaysia, Egypt and Saudi Arabia by adopting a dual/parallel banking
system. However, Pakistan should be mindful of the factors, which have
so far impeded the development of Islamic banking in Pakistan.

There is a desire among many to see the whole of
Pakistan's economic system Islamised as soon as possible. However, it
a mammoth job needing research, for setting up of controls and
designing of new operational procedures and documentation. Undue haste
may lead to serious problems, which would surely be exploited by the
critics to discredit the whole Islamic system.